August 07, 2007

Should industrial policy be fit for polite company?

You read the title, and you say "here he goes again." OK, I admit it. I have been a bit obsessed with industrial policy lately. But there is a reason. I have been writing another paper on the subject, as an input to the work of the World Bank's Commission on Growth and Development. The Commission is headed by Michael Spence (who has turned his attention to growth and development recently), and its secretary is the very able and sensible Roberto Zagha.

Here, as a teaser, is an excerpt from the introduction:

Consider a set of policy interventions targeted on a loosely-defined set of market imperfections that are rarely observed directly, implemented by bureaucrats who have little capacity to identify where the imperfections are or how large they may be, and overseen by politicians who are prone to corruption and rent-seeking by powerful groups and lobbies. What would your policy recommendations be?

You might be excused for thinking that I am referring to industrial policy and if you react by saying “these are all reasons why governments should stay away from industrial policy.” But in fact what I have in mind are some of the traditional, long-standing areas of government intervention such as education, health, social insurance, and macroeconomic stabilization. All of these policy areas share the features described in the previous paragraph. Yet, curiously in light of the skepticism that attaches to industrial policy, almost no-one questions whether they properly belong in the government’s arsenal.

Consider the parallels with industrial policy. Interventions in each one of the conventional areas I just listed are justified by market failures that are widely felt to exist, although rarely documented with any precision. So education and health interventions are motivated by human capital externalities, social insurance by asymmetric information, and stabilization policy by aggregate-demand (Keynesian) externalities (to list just some of the more prominent market failures). Systematic empirical evidence on these market imperfections is sketchy, to say the least, which is why there continue to be vibrant academic debates on their role and magnitude. Even the least controversial among them, positive externalities associated with schooling, have proved difficult to pin down convincingly.

Moreover, in each one of these areas bureaucrats have wide latitude in implementing policies, while remaining in the dark about the nature of the root problems. Spending ministries make budget allocations with little capacity to evaluate the impact of their decisions. Bureaucratic routine rather than economic logic determine much of the behavior on the ground. And powerful groups and lobbies typically exert significant influence on the policy process. In education, teachers’ unions have a loud voice on what should be done (or cannot be done). In health policy, it is often insurance firms and the medical doctors’ association who get their say. Tax and spend decisions are similarly subject to influence from organized lobbies. All these shortcomings notwithstanding, the debates in these policy areas are rarely ever about whether the government should be involved; they are about how the government should goabout running its policies. It’s not about whether, but about how.

Why can't industrial policy be the same? It's beyond me.

The paper describes the market failures that call for industrial policy (they are in fact central to the way economists think about development), evaluates available empirical evidence (inconclusive, by the very nature of the methodologies employed), discusses existing industrial policies in a few non-Asian countries (there is a lot more of it than you might think), and proposes some "design features" to reduce the agency costs opponents are concerned about (it can be done).

In light of the recent exchanges in around this blog, let me emphasize that last bit in particular. A key point of the paper is that the shortcomings of governments should not be taken as a given. Just as economists think about how to improve market institutions, they can devote their talent to improving the institutions of government. The informational and rent-seeking costs of government intervention can be ameliorated through appropriate institutional design.

1. I do not understand the final question on “Why can't industrial policy be the same? since what we have read up to that point is about how unfit education and health interventions are. Is this a “Momma if they can get their hands dirty why can’t I” generalized clamor?

2. Industrial policies do work when they feel naturally right and are implemented in a country that has an ongoing purpose and a working business model, and they never work correctly when they are carried out because they just are deemed to be appropriate.

3. Danni states. “A key point of the paper is that the shortcomings of governments should not be taken as a given. Just as economists think about how to improve market institutions, they can devote their talent to improving the institutions of government. The informational and rent-seeking costs of government intervention can be ameliorated through appropriate institutional design.”

He is of course right but the analysis needs also to include the possibilities of scrapping the institutions altogether so as not having to live with some not worse results. Let me put it this way. In a country where a military dictatorship financed by an oil boom reigns, it is much better to scrap all together the Congress, the Supreme Court and the electoral apparatus, than to think of wasting time improving them, and no matter how well they function in other countries.

My thinking on industrial policy has changed after spending a year in Germany. OK, this is a developed country, and lessons cannot be generalized without considerable caution. Nevertheless, industrial policy is ubiquitous there, works more or less as advertised, and the result is the most successful export machine in the world, when one considers the role of exchange rates.

But Germany reveals the bad side of industrial policy as well. There is plenty of corruption and incompetence; lots of projects are boondoggles, and the interplay of money and influence casts a shadow over much of federal and regional politics.

My take is that the strength of the system lies in its deep institutionalization. IP is rooted in the programs of employer associations, in the training and apprenticeship system, and in the allocation of capital by public and quasi-public financial institutions. Enough people with enough direct experience with what works (and with reasonable incentives connected to outcomes) participate at the bottom and middle layers that the apparatus as a whole can survive the indignities that flow from the top. And even these indignities are moderated by the familiarity of voters with the needs of successful innovation and development, so that the public discussion of IP issues is relatively sensible.

Incidentally, the value of IP is not on the table in Germany: all major parties agree that it is central to the national strategy, and disagreements are over the content.

How much of this can be translated to developing country contexts? It is common to say that the German system was built on foundations that extend back to the medieval guild system -- what does this say about countries and cultures with profoundly different histories?

Perhaps the only lesson I can draw is that attention needs to be given to the lower and middle layers of the apparatus, rather than only the policy direction from the top. (The analogy I am most familiar with would be education, where the strength of a strong public system rests on the classrooms and schools, and not primarily on centralized policy choices.) But this presents more questions than answers for countries without a pre-existing set of institutions.

My comment is rather simple and comes from managing a developing trade and development department. The fundamental constraint is capacity of those who peform at the middlelevel of staff/managers. I've always subscribed that capacity building and training abroad are necessary tools for IP decision-makers. No one case is readily replicated from one less developed country to another. So, in the final analysis, Asean countries moved up the ladder only when inputs into capacity building started to impact IP and its delivery down to exports.
The case of Germany (today) cannot be easily compared - even within EU. Industrial culture and capacity for innovation is integral to German exporters. And there is no indication it's getting less competitive with expansion of EU-27. In fact, even with current Euro appreciation, there's hardly any serious public discussion on its impact on on-going exports. Implication being that in final analysis export QUALITY really counts!

Do folks have ideas how one would measure the extent of market failures related to industrial policy rationales? Some ideas come to mind. With imperfect competition of course we have the HH index, with environmental externalities one can use damage cost functions. Access to credit is also fairly easy to get data on. But, what about coordination or information failures? Has anyone actually measured those in the North and South?

"My take is that the strength of the system lies in its deep institutionalization...in the training and apprenticeship system...It is common to say that the German system was built on foundations that extend back to the medieval guild system -- what does this say about countries and cultures with profoundly different histories?

Perhaps the only lesson I can draw is that attention needs to be given to the lower and middle layers of the apparatus, rather than only the policy direction from the top. (The analogy I am most familiar with would be education, where the strength of a strong public system rests on the classrooms and schools, and not primarily on centralized policy choices.) But this presents more questions than answers for countries without a pre-existing set of institutions."

Japanese development programs are exemplary in this respect, from multinational's with training programs in real-time programming to the one village one product idea that has been adopted throughout the world. The Japanese programs I've seen work on the ground at the grassroots level, the western ones I've seen at firsthand, fly in, stay at a hotel, offer a bunch of ill-informed advice, fly out.

"Yet, curiously in light of the skepticism that attaches to industrial policy, almost no-one questions whether they properly belong in the government’s arsenal."

You need to get out more. This might be true in your department, but it certainly isn't true of the GMU department.

And I think you are drawing a very wrong conclusion from this point...rather than thinking "maybe we should question whether or not education policy et al. belong in the government's arsenal," you conclude that "we should stop questioning whether industrial policy belongs in the government's arsenal."

It makes absolute sense. Therefore, if one thinks that divorces are the failures of private individuals ex post, I'm sure we could set up new laws to make all marriages be arranged through the government. As Dani says, it's not whether, but how.
More seriously, the government may get involved in education, say, because we want all individuals to "consume" a minimum amount of education. Why should this be so with industrial policy? Firms are not children.

"Systematic empirical evidence on these market imperfections is sketchy, to say the least, which is why there continue to be vibrant academic debates on their role and magnitude. Even the least controversial among them, positive externalities associated with schooling, have proved difficult to pin down convincingly."

Perhaps because they aren't really there? The most powerful arguments for intervention in healthcare and education have been agency (in the case of matters involving children) and distributional justice, not market failures. The externality arguments seem to be weakly supported and if they were the only arguments being marshalled, interventions in those areas would probably recieve the same frosty reception that they do in industrial policy.

"Yet, curiously in light of the skepticism that attaches to industrial policy, almost no-one questions whether they properly belong in the government’s arsenal." Deni Rodric

The reason that industrial policy does belong in the government's arsenal, at least democratic government's arsenal, is that industrial policy effects a variety of stakeholders, and with democratic government there is a check on the encroachment by the powerful.

If we left policy to the industries themselves the tendency would be to preempt policy for their benefit to the exclusion of everyone else. We see this happening in semi-autonomous public utility commissions. They tend to be taken over by the industries they are supposed to regulate.

This same encroachment can happen within government itself. For instance, trade policy being driven by corporations to the detriment of labor.

Anyone who watched the Democratic debate sponsored by the AFL-CIO could see that corporations are losing the public relations battle over trade policy. It's becoming harder for Democratic candidates who want to gain executive power to ignore labor's complaints. This is partly because corporations have acted in ways that have made them reviled, partly because those candidates who attacked our free trade policies won in the last congressional election, partly because predictions about the benefits of free trade have been a very mixed bag--NAFTA for instance didn't slow down illegal immigration, and partly because government hasn't acted to mitigate the bad effects of free trade on its citizens--globalization causes citizens to change jobs more often during their lifetime where is the continuous medical coverage and pension coverage to go with the job changes.

Bad trade policy helps to change government power and change in government power helps to change bad trade policy.

Some people may think this isn't a blessing at all. They might argue that off again, on again policy is bad for the country, and to the extent that we leave policy in the hands of the people we take it out of the hands of experts. But what is a democracy for if the stakeholders who have an interest in the outcome of policy decisions can't ask for procedural fairness.

That's the beauty of industrial policy as part of government's arsenal, it can be wrenched back from the hands of the usurpers, no matter who they are, and it's in the hands of people who have the responsibility to mitigate foreseen or unforeseen consequences and can be pressured to do so.

Oh, one other thing, if the question is should governments have industrial policies at all, it's hard to see how not having an industrial policy would be possible in a democracy.

Dani, I've been reading your industrial policy articles and have a question. In industrial policy for the 21st Century I come away with the idea that it is not important to pick specific focus sectors or clusters, and as long as the government has clear criteria e.g. in terms of spillovers, employment etc, and various tools such as public venture funds, it should be able to respond / intervene to support any private sector ideas that meet its broad support criteria. On the other hand the articles on SOuth Africa seem to endorse the idea that it is better to identify a range of specific sectors or clusters and focus the process of dialogue with the private sector around these specific sectors. Have I misunderstood or are your ideas evolving in this way?

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My take is that the strength of the system lies in its deep institutionalization...in the training and apprenticeship system...It is common to say that the German system was built on foundations that extend back to the medieval guild system -- what does this say about countries and cultures with profoundly different histories?

“A key point of the paper is that the shortcomings of governments should not be taken as a given. Just as economists think about how to improve market institutions, they can devote their talent to improving the institutions of government. The informational and rent-seeking costs of government intervention can be ameliorated

Perhaps the problem is with the misnomer "developing country". Countries that don't have the basics of "peace, easy taxes, and a tolerable administration of justice" may well indeed be caught in a Malthusian trap where greater national income gets translated into high population but not per capita GDP.

That's the beauty of industrial policy as part of government's arsenal, it can be wrenched back from the hands of the usurpers, no matter who they are, and it's in the hands of people who have the responsibility to mitigate foreseen or unforeseen consequences and can be pressured to do so.

But...hey! Do you have a faint ideas how one would measure the extent of market failures related to industrial policy rationales? Some ideas come to mind. With imperfect competition of course we have the HH index, with environmental externalities one can use damage cost functions

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You need to get out more. This might be true in your department, but it certainly isn't true of the GMU department.

And I think you are drawing a very wrong conclusion from this point...rather than thinking "maybe we should question whether or not education policy et al. belong in the government's arsenal," you conclude that "we should stop questioning whether industrial policy belongs in the government's arsenal."

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I think this is a great post. One thing that I find the most helpful is number five. Sometimes when I write, I just let the flow of the words and information come out so much that I loose the purpose. It’s only after editing when I realize what I’ve done. There’s defiantly a lot of great tips here I’m going to try to be more aware of.

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Well, industrial policies vary, there are some that comply with law, and are formulated to do what is right that will benefit both the public and the industries involved. There are also some industrial policies that are just put together to cheat, and manipulate the law and the public. For any polite company out there; following honest industrial policy is a good thing.

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That's the beauty of industrial policy as part of government's arsenal, it can be wrenched back from the hands of the usurpers, no matter who they are, and it's in the hands of people who have the responsibility to mitigate foreseen or unforeseen consequences and can be pressured to do so.

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Dani, I've been reading your industrial policy articles and have a question. In industrial policy for the 21st Century I come away with the idea that it is not important to pick specific focus sectors or clusters, and as long as the government has clear criteria e.g. in terms of spillovers, employment etc, and various tools such as public venture funds, it should be able to respond / intervene to support any private sector ideas that meet its broad support criteria. On the other hand the articles on SOuth Africa seem to endorse the idea that it is better to identify a range of specific sectors or clusters and focus the process of dialogue with the private sector around these specific sectors. Have I misunderstood or are your ideas evolving in this way? altın çilekformula 21